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Income to drive real estate returns as yield cycle nears end

The prospect of robust global economic growth in the coming years should prove positive for occupier demand, but could present fresh challenges to real estate investors as interest rates rise around the globe.

3 minute read

Income is the key driver of long-term total returns in real estate, as markets are highly cyclical and inefficient. For a start, investor flows in and out of the sector exert a critical influence over short-term movements in capital values. Various factors, including the vagaries of the economic cycle and the relative value of yields in real estate and competing assets such as fixed income, influence these flows. Over the next five years, the supportive global economic backdrop should support rental income but will also cause interest rates to rise, heightening the appeal of other asset classes. Consequently, yields in the property sector are likely to rise gradually.

Strong global growth

We have revised our global growth forecast for this year upwards to four per cent. In 2019, we anticipate a slight moderation in global growth to 3.7 per cent as the major economies slow modestly towards their long-run sustainable rates. However, with growth expected to remain well above trend in all major economies in 2018, labour markets should continue to tighten as spare capacity is eroded. That is expected to put upward pressure on wage growth and inflation. We have revised up our expectation for inflation in advanced economies to two per cent in 2018.

Given the growth and inflation outlook, we expect most central banks around the world to be biased towards tightening monetary policy. The Federal Reserve (the Fed) is furthest along the path, having raised rates to 1.5-1.75 per cent in March. We now expect a total of four rate hikes from the Fed in 2018 and another four in 2019, taking the policy rate to over three per cent.

That is a more rapid pace of rate increases than we had expected at the end of last year and reflects the combination of stronger-than-expected underlying growth momentum, the material boost from tax cuts and increased fiscal spending, and the increased likelihood inflation will overshoot the two per cent target in 2019. In the euro-zone, we expect asset purchases to end in late 2018 (with a first rate hike in 2019), while in Japan, the Bank of Japan could review its policy of yield curve control if core inflation continues its recent steady rise to above one per cent. The outlook for the Bank of England remains dependent on developments in the Brexit negotiations, but the current balance of risks suggests at least one rate hike this year.

Positive background for income growth but yields set to rise

Rising economic activity will fuel occupier demand for prime commercial space in major markets around the world as the number of new start-ups increases and existing businesses seek to grow further. This should result in healthy increases in rental income in the coming years across most sectors.

However, the tightening of monetary policy is likely to prove less positive for capital values in real estate. Yields on commercial property should increase as the income from risk-free assets, such as treasuries, become more appealing to investors. Indeed, the bottom of the current yield cycle is likely to be reached over the next 12-18 months as funds flow out of property towards other asset classes. That said, yields should remain below historic averages.

Figure 1: The end of the yield cycle is nigh

The US and UK will lead the wave of pricing corrections, mainly because they have led the advance in the global property cycle in recent years. The fact that interest rates will rise fastest in the US will also exert downward pressure on capital values across the Atlantic, while Brexit will add a further degree of uncertainty to the UK’s economic outlook. Price declines should prove particularly marked in areas where the rise in rental incomes is weakest.

The industrials/logistics sector has the strongest outlook in terms of total returns, followed by retail and office space. Global growth is boosting industrial production around the world, while, logistics is benefiting from fierce online demand for retail goods: modern warehousing close to cities that can accommodate new technologies should continue to enjoy robust demand. The US and Benelux markets are expected to do particularly well.

Asset management initiatives, such as refurbishing or adding floor space to properties, will provide another means to boost income growth and capital values. Careful selection at the individual property level will prove critical, requiring expertise in specific locations, such as emerging neighbourhoods in key global cities. These are areas that are benefiting from gentrification or becoming technology hubs.

There are also opportunities for capital growth in certain areas, including European retail which has been buoyed by increased consumer spending and the growth in Asian tourism.

It is also possible to pinpoint global cities primed for growth. Singapore office space and Hong Kong retail are both poised for a cyclical recovery in rents, where they have been re-based. Hong Kong has suffered significantly from a decline in visitors from mainland China. Reasons behind the decrease include Beijing’s crackdown on luxury spending and Europe’s increasing allure as a destination for Chinese tourists. Singapore, meanwhile, has a highly-compressed property cycle and the island republic is poised for recovery, with rents still significantly lower than in 2007.

Figure 2: Total returns to decline as yields gradually rise

Total returns fall, pricing at pre-crisis levels

Overpricing in global real estate markets is moving to levels last seen prior to the global financial crisis, with capital pricing likely to come under pressure over the next five years. Investors will continue to enjoy positive total returns over our forecast period of 2018-22, but they are likely to prove lower than in the recent past and be increasingly reliant on gains in rental income, rather than the robust capital growth seen in recent years.

Authors

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at April 26 2018. Unless stated otherwise any view sand opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment.

In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes. In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583.In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000

The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606

RA18/0469/01042019

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